Interest Rates for Federal Subsidized Loans to Jump to 6.8% on July 1, 2012

In his State of the Union address, President Obama proposed that Congress stop the student loan interest rate from doubling in July 2012. Without Congressional intervention, the interest rate for Federal Direct Subsidized Loans for undergraduates will increase from 3.4 percent to 6.8 percent beginning July 1, 2012.

Prior to the Obama's proposal, it may have seemed unlikely that Congress would intervene, due simply to the state of the U.S. economy, a continued push towards austerity, and an unbalanced federal budget. But, one day after the Presidents annual address, Rep. Bruce Braley, R-Iowa, introduced legislation to keep the interest rate at 3.4 percent indefinitely.

"It’s hard not to be discontent with the next interest rate change, particularly in the context of all the other student financial aid cuts we’ve seen this year," NASFAA Policy Director Megan McClean said.

What Does It All Mean?

The reason why the rate is set to change to 6.8 percent has a lot to do with decade-old, long-term interest rate calculations and 2007 legislation aimed at easing student loan debt.

From 1965 through 1993, interest rates on student loans were fixed. In 1993, congress changed the interest rate on student loans to a variable rate based on market interest rates. Each July 1, the U.S. Department of Education would set the interest rates for federal student loans originated in that year based on the 91-day rate from the most recent Treasury auction held in May. In 2002, Congress enacted legislation (P.L. 107-139) to set a new interest rate structure that would fix student interest rates at 6.8% beginning July 2006. The 6.8 percent rate was based on Congressional Budget Office projections showing that rate to be the average rate that would result in 2006 from the variable rate formula already in place.

In 2007, the College Cost Reduction and Access Act (CCRAA), designed to relieve some of the burden of education loan debt for the nation’s students, phased in cuts to the fixed interest rates on newly originated subsidized Stafford loans for undergraduate students. Under the CCRAA, the interest rates on subsidized Stafford loans decreased from 6 percent in 2008-09, to 5.6 percent in 2009-10, 4.5 percent in 2010-11 and 3.4 percent in 2011-12. Unsubsidized Stafford loans and all graduate level Stafford loans have remained at a fixed 6.8 percent rate.

Democrats in Congress initially wanted to reduce interest rates on all federal student loans, but early analysis showed such an initiative would be too costly, according to the New America Foundation’s Federal Education Budget Project Director Jason Delisle.

“The bill had to save as much as it spent,” Delisle said. In order to make the change budget neutral, the cost of the interest rate reductions could not exceed budget savings created by cuts to lender subsidies. In order to reduce the cost of the interest rate reduction, lawmakers decided to phase in the interest rate reduction over time and eventually return to a 6.8 percent interest rate after five years, to the dismay of many student borrowers.

With tuition costs rising and a downturn in the economy, more students are taking out loans and a growing number are taking out federal Stafford Loans. According to the College Board’s 2010-11 Trends report, the percentage of students taking out federal Stafford loans during the last academic year increased from 22 percent in 2000-01, to 28 percent in 2005-06, and to 34 percent in 2010-11. A growing portion of these students are also taking out a combination of both subsidized and unsubsidized loans.

When the Obama administration announced in October that it planned to make minor changes to the Direct Loan Program to help struggling borrowers, many wondered why an interest rate reduction was not included. Many argue that because the government borrows at less than half the rate it provides student loans, the 6.8 percent interest rate is too high and the government is making a profit on the federal Direct Loan program.

However, federal student loan interest rates are determined by Congress, not the President, so legislation is needed to prevent the jump to 6.8 percent in July. In addition, the federal government provides a number of protections for borrowers outside of interest rate protections, including extended, 30-year repayment plans, forgiving student loans that meet certain criteria and absorbing the risk associated with providing loans without credit checks. Many private loans do not offer these type of protections and rates are variable and dependent on credit history. Many private lenders are not willing to take on the risk associated with lower interest rates, Delisle said.

Still, some higher education experts argue that 6.8 percent is still too high, given the economic climate.

“The 6.8 percent fixed came about during a time of high interest rates when advocates for students thought a fixed rate would protect them from high rates,” College Board policy analyst Sandy Baum said. “Now of course 6.8 percent seems absurdly high. It doesn’t make sense for students ever to pay higher than market rates. But it also doesn’t make sense for the extent of the taxpayer subsidies to students to be so random and changing.”

NASFAA President Justin Draeger points to the constant tension between simplicity and equity. “A fixed interest rate is simpler for students to understand, but also creates inequities in the student loan programs, most visible in periods where student loan rates are far above market rates.”

Baum also believes there are inequities in a 6.8 fixed rate. “It’s a problem that the exact time you take your loan determines the permanent interest rate on the loan,” she said. “How could it reasonable for a student who borrowed this year to have 3.4 percent for the life of the loan and a similar student who borrowed either last year or next year to have a higher rate?”

Still many students will feel the burn when interest rates for federal subsidized Stafford loans increase from 3.4 to 6.8 percent. The change is coupled with cuts to other federal financial aid programs, including the elimination of year-round Pell, the Leveraging Educational Assistance Partnership (LEAP) Program and the six-month grace period interest subsidy for Stafford loans.